Thread by @adamkwolfe

China isn’t just trying to be the leading high-tech manufacturer. It’s also wants to manufacture everything. This goes against the typical development pattern and most economists’ advice. So why does Xi want to do it, and can he pull it off? A long🧵 1/

This is from a note I wrote a few years ago (so all the charts are stale). I was re-reading that for a new project I’m working on, and then also read this great blog post from @andrewbatson on the topic. So maybe it’s vaguely topical? 2/ andrewbatson.com/2023/10/03/chi…

@andrewbatson Anyway, the goal of maintaining the manufacturing share of GDP is buried in a single sentence in chapter 8 of the 2021-25 five-year plan. But what that means is that the long-standing goal of boosting the service sector’s share was dropped. 3/

@andrewbatson A rising share of services in GDP was one of four headline economic development targets in the previous plan, and one of three in the plan before that. But it was dropped completely for the current plan. 4/

@andrewbatson The argument for maintaining a large manufacturing sector is rooted in two objectives – boosting productivity and ensuring economic security. The first line of thinking leads back to the ideas of William Baumol. 5/

@andrewbatson Baumol noted that there are “progressive” sectors in which productivity gains are possible, and “stagnant” sectors in which they’re not. Manufacturing is the classic example of the former, while some services, like a theater production, are the latter. 6/

@andrewbatson Baumol’s “cost disease” postulates that relative price changes will shift nominal demand and labor composition toward the stagnant sector. Growth will suffer as a result. China’s recent history would seem to confirm that. 7/

@andrewbatson US sanctions are the other reason to hold on to low-end manufacturing. As Xi put it in 2020, China “must build a domestic supply system that is independently controllable and secure and reliable, so that self-circulation can be accomplished at critical moment.” 8/

@andrewbatson OK. That’s the “why”. What about the “how”? There are a handful of countries that are richer than China with similar or larger sized manufacturing sectors. Taiwan and Korea are the best examples. 9/

@andrewbatson Czech, Germany and Slovenia have slightly smaller manufacturing sectors as a % of GDP, but are probably decent examples, too. Ireland, Singapore and Swiss are less good examples because they don’t actually employ that many people in manufacturing. 10/

@andrewbatson The main thing is that all these countries held on to their large manufacturing sectors has they got richer, which goes against Baumol’s cost disease theory. So China probably has something to learn from them. 11/

@andrewbatson So what do they have in common? First, they all have unusually high gross savings rates. That’s allowed for large scale investment in new capacity, and it’s probably what protected their manufacturing sectors from being hollowed out. 12/

@andrewbatson That shouldn’t be a problem for China. Its gross savings rate is going to decline due to demographics, but will probably remain unusually high. 13/

@andrewbatson Second, they all have light tax regimes. Since capital can go anywhere to finance manufacturing capacity, it tends to go where its treated best. This is the primary reason that Ireland, Singapore, and Switzerland are on the list. 14/

@andrewbatson Note that China’s tax take is under stated in the previous chart because its tax system is unusually decentralised. It would really sit just to right of Korea in the chart, but its overall tax rate has been declining since 2020… 15/

@andrewbatson This decline in taxation is obviously a problem for local governments. And it’s a problem for Xi’s Common Prosperity goals, too. So I don’t think China is going to be able to copy Ireland’s strategy. But that shouldn't be a binding constraint. 16/

@andrewbatson Third, all the rich, large manufacturing countries are open economies (high trade/GDP ratios). This is where China really can’t follow their path. It’s just way to big to be an open economy. 17/

@andrewbatson Charles Kindleberger described how geography and development interact to determine a country's openness. Early in development, trade tends to expand faster than GDP as higher incomes lead to demand for things that cannot be made at home. 18/

@andrewbatson But as demand shifts toward construction & services, trade intensity tends to decline. And as internal markets develop, domestic producers enter and drive out exports. And as the domestic value of exports rises, imports tend to decline. 19/

@andrewbatson Plus, geography is also important since trade patterns are largely dictated by factor endowments and transportation costs. Larger countries (in size and $) have more domestic resources and so tend to trade less with others. 20/

@andrewbatson Since China is well endowed both in terms of GDP and geography, it will never be an open economy again. Here’s the same chart from the last post without the log scale. China & the US stand apart, and trade mostly with themselves. 21/

@andrewbatson Finally, China’s scale is a problem in another way. All the rich, large manufacturers run large current account surpluses. In effect, they avoided Baumol’s cost disease by producing goods for the global economy and exporting their surpluses. 22/

@andrewbatson Even as relative prices pushed the demand side of their economies toward services, the supply side of their economies remained skewed toward manufacturing. But China is just too big to do that b/c it can’t realistically gain much more export share. 23/

@andrewbatson So what is China going to do? China’s policymakers argue that it has something the other rich manufacturers don’t – a massive and rapidly growing domestic market for goods. 24/

@andrewbatson The plan is to create an integrated national market by breaking down provincial barriers to trade, starting with city clusters. Factor price reforms should improve the functioning of its markets. 25/

@andrewbatson And if wasteful real estate investment can be curtailed, then the savings rate can come down a bit to boost consumption without dragging manufacturing down with it. 26/

@andrewbatson If all goes to plan, the domestic economy will partly substitute for the global market in the development pattern of other rich, manufacturers. But, of course, this is where Baumol’s cost disease becomes a problem. 27/

@andrewbatson Automating manufacturing will lower its share of employment & nominal GDP, which means the less progressive service sector will have to drive growth in the future. The other countries only avoided that by suppressing consumption & exporting their surplus production. 28/

@andrewbatson So this isn’t a magic bullet to prop up China’s GDP growth. But growth is probably secondary to economic security to Xi, so that’s probably not a reason for him to try something else. That was too long, so I’ll end it here. 29/29